Leveraged Currency

Currency investors now have two new options: the Market Vectors-Double Long Euro ETN (NYSEArca:URR) and the Market Vectors Double Short Euro ETN (NYSEArca:DRR). These funds introduce leverage to the dollar/euro trade and bring the count of currency ETFs to around twenty. We expect these funds to be popular with investors as well as traders in the hot currency area despite the crowded field.

DRR and URR are different from previous offerings because they provide the equivalent of double exposure to the movement of dollar/euro. They do this by tracking an index invented by Morgan Stanley for the purpose: the Double Long Euro Index (DLONGEUR). DLONGEUR is supposed to move at twice the rate of the euro/dollar trade. The long euro-short dollar fund is URR. The long dollar-short euro fund is DRR.

DRR and URR are ETNs (exchange traded notes) and as such differ from currency products like PowerShares Deutsche Bank US Dollar Index Bullish (AMEX:UUP) and the CurrencyShares Euro (NYSEARca:FXE). Whereas funds like UUP are composed of futures contracts set to replicate a long position in the US Dollar against a basket of euros, yens, pounds, Swiss francs, etc., a position in DRR and URR may be backed by nothing. Like other ETNs they are essentially promises from the issuer (Morgan Stanley) to pay based on the performance of the tracking index.

So although they are convenient and efficient, URR and DRR do carry the credit risk of any other Morgan Stanley senior unsecured debt security. Prior to the collapse of Bear Stearns any default would have been unthinkable. Now some of our readers are raising questions about the default characteristics of ETNs. ETFZone believes that like other ETNs trading in the market these today these are reasonably safe vehicles with respect to default.

On the issue of leverage on the other hand we think our readers should proceed with caution. Any leveraged product involves additional risk. But the risk associated with currency ETFs may be less than that of many equity leveraged products. Historically currency does not move as fast as most equity. Foreign currency investments also tend to have low correlation with broad index benchmark funds like the Standard and Poor's Depositary Receipts (AMEX:SPY).

The question of how much is too much leverage is generally related to the volatility of the security. So how volatile is the dollar? Since 2001 the euro has appreciated approximately 60% against the dollar. An untended long position in a long dollar leveraged product would obviously have had very serious consequences for the buy and hold investor. Any leveraged product needs to be monitored. On the other hand, professional currency traders who monitor their positions by the minute often use much higher leverage: 25-1 or even higher. In comparison the leverage here is modest.

For ETF investors new to the idea of owning currency products, global currency markets carry specific risks unfamiliar to domestic equity and bond investors. But they also can mean significant opportunities. Some of the most reliable profit for many investors has come from the movement in the dollar. Arguably, the dollar's rapid plunge against the euro has reshaped the world. The price of oil, for example, which is sold in dollars, has because of the dollar/euro trade not appreciated in Europe as it has in the states.

The collapsing dollar has made winners of virtually all equity ETFs denominated in foreign currency, regardless of performance. The chart below shows the performance of the Vanguard European ETF (AMEX:VGK) and compares that with the long currency ETF FXE.

vgk

As the chart above shows over a two-year period VGK has appreciated about 15%. FXE (which tracks the euro) has appreciated about 20%. VGK is profitable in dollars because it is denominated in euros. Hedge out the foreign exchange and VGK would be a loser over this period.

At ETFZone we do not make specific recommendations on securities for purchase or sale through our news service. We do think however, that markets are characterized by mean reversion. The seven year downtrend in the dollar has us looking for a rebound in the currency. Possible triggers include a cessation of interest rate cuts at the Federal Reserve, an improving credit picture and a slowing of dollar diversification among investors as U.S. equities become more attractive.